Properties of a Valid Benchmark

(ARTICLE WRITTEN BY KRISTIAN CAMENZULI)

Different asset classes exhibit different risk and return characteristics. The use of passive benchmarks serves to represent those risk and return characteristics as used in an asset mix study, leading to the optimal strategic asset allocation mix. The quality of active management mandates are measured against such benchmark.

A benchmark is a point of reference for measuring performance. A choice of benchmark can greatly influence decisions throughout the investment process. When selecting investments such as mutual funds or separately managed accounts (discretionary portfolios), benchmarks are useful to assess a fund manager’s skills and track record.

Benchmark Indexes

Benchmark indexes have been created across all types of asset classes. In the equity market, the S&P 500 and Dow Jones Industrial Average are two of the most popular large cap stock benchmarks. In fixed income, examples of top benchmarks include the Barclays Capital U.S. Aggregate Bond Index, the Barclays Capital U.S. Corporate High Yield Bond Index and the Barclays Capital U.S. Treasury Bond Index.

The Good

Good benchmarks increase the proficiency of performance evaluation and enhance the plan sponsor’s ability to control total portfolio risk.

The Bad

Bad benchmarks obscure manager skills and promote inefficient manager allocations, and increase the likelihood of unpleasant surprises in total fund performance.

The essential properties of a benchmark

The essential properties that an investment benchmark should possess are as follows:

1. Specified in advance – the benchmark needs to be known before and investment manager starts managing a portfolios

2. Appropriate – the benchmark is in line with the manager’s style of investing

3. Measurable – the benchmark’s return can be easily calculated

4. Unambiguous – the identities and weights of securities can be clearly identified

5. Reflective of current investment opinions – the investment manager knows the companies in the benchmark and has an opinion on them

6. Accountable – The manager is aware and accepts accountability for the constituents and performance of the benchmark

7. Investable – you can actually buy the benchmark

These qualities are easily remembered through the acronym SAMURAI.

Conclusion

Irrespective of whether you manage your own portfolio or you opt of a discretionary managed service, it is always important to measure performance not only to see whether your portfolio outperformed the market in general, but also to learn from your mistakes and improve your investment skills.